Fed should be sole money creator

Knoxville viewpoint: Fed should be sole money creator
Knoxville News-Sentinel

Sunday, March 7, 2010

The Federal Reserve has just sent mixed signals. It raised the discount rate by 25 basis points to 0.50 percent and yet told Congress the very next week that it plans to leave its Fed funds rate unchanged at 0.25 percent.

The discount rate is what the Fed charges those who want to borrow at its Discount Window for liquidity purposes. This rate usually is 1 percent above the Fed funds rate - the rate banks charge other banks on overnight loans. When the financial crisis was at its peak, the Fed lowered the discount rate, and Discount Window borrowings peaked at $100 billion.

Since the crisis has subsided, loans have fallen to $10 billion, so the Fed decided there was no need to provide as much cheap borrowing to the banks.

However, Fed Discount Window loans, coupled with its asset-backed securities purchases of mortgage-backed securities and commercial paper, have caused the monetary base (currency plus bank reserves) to increase from $813 billion in 2006 to $2 trillion in December.

Although some people have claimed that the Fed has doubled the money supply, that is not true.

The most commonly used definition of money is M2, which is checkable deposits, currency in the hands of the public, and small time and savings deposits. M2 has increased from $6.6 trillion to $8.5 trillion. But the base is the money supply's fuel.

Banks create money by lending out of excess reserves, and the banks now are sitting on $1 trillion in excess reserves. If demand in the economy recovers, and the banks lend out the money, the result will be an explosion in the money supply and in inflation.

The Fed says it is not worried because it can discourage bank lending by paying more interest on excess reserves. Others, including me, are skeptical.

Some have suggested that the Fed double the reserve requirement from 10 percent to 20 percent, which lessens the ability of banks to generate money by forcing them to hold more reserves. That is a very bad idea. The last time the Fed tried this was in 1936, which led to banks curtailing lending to rebuild their reserves. The result was the 1937 return to depression.

No. A better idea would be for the Fed to raise permanently the reserve requirement to 100 percent. Of course the banks could not lend either. Rather this would create what Milton Friedman called the "narrow bank." Lending would then be conducted out of a subsidiary in the bank's holding company, which would borrow the money it lends, just like finance companies, mortgage banking companies, insurance companies and investment bankers.

This way the banks could not generate money and destabilize the economy. Rather, money creation and destruction would rest entirely with the Fed - where it belongs.

Dr. Harold Black is the James F. Smith Jr. Professor of Finance at the University of Tennessee. He can be reached at hblack@utk.edu.